Be Glad That Corporate Liability Is Limited

If you run in libertarian circles, you hear a lot about lawsuits. It’s the obvious recourse for anyone who wants less regulation but can’t bring themselves to insist that, say, chemical companies should be allowed to dump toxic waste into your water supply. If you stick around long enough, you’ll hear someone advocate eliminating limited liability entirely: making corporate owners liable for anything that a firm ever did.

It’s an idea I’ve always found intriguing. And because it popped up in the comments to this post (from a nonlibertarian), and because it’s Friday, I thought it worth explaining exactly why it’s unworkable.

The argument for unlimited liability isn’t just a libertarian evergreen; it’s also something you occasionally hear from the far left, because it would basically make the corporate form untenable. Imagine, if you would, that by buying and holding the share of a firm for 10 minutes, you thereby subjected yourself to seizure of all your goods to satisfy potential lawsuit judgments -- even if those judgments involved behavior that involved no legal liability at the time of the acts.

Not possible? That’s basically what happened with asbestos liability. Firms that had had no legal liability under the doctrines of the times in which the asbestos was sold or used suddenly found themselves driven into bankruptcy by massive settlements. Moreover, after the first wave of lawsuits exhausted the funds available to pay asbestos claims, plaintiffs' lawyers started pushing to expand the number of pockets that could be dipped into.

A company that had never manufactured asbestos could be sued and have to spend hundreds of millions of dollars on lawsuits and settlements because it had once bought a company with an insulation division that had formerly manufactured asbestos -- even though it had immediately sold off that division in the process of completing the merger. Insurers could be forced to pay out for the whole of a company’s liability if they had sold a company insurance for even a year between the time a company started making or using asbestos and the time that the plaintiff discovered the harm. And “harm” wasn’t limited to getting sick; you could sue for the emotional distress of worrying that you might get sick.

Kind of hard to imagine becoming a shareholder under those circumstances, isn’t it? Maybe you’d better put your money in the bank -- a small, privately held bank, of course. Commerce would look something like it did in medieval Italy, where all economic activity was basically organized by the family or the partnership.

Growth would have to be financed by debt or by retained earnings. That’s how British firms financed expansion in the early days of the Industrial Revolution. It’s how small businesses tend to finance expansion now.

This would change the kind of investing people can do, however. Debt finance means that your investment has to pay off pretty quickly; otherwise, the payments drive you into bankruptcy before you can launch your product. Financing out of retained earnings, on the other hand, is best for investments that are pretty cheap and smoothly scalable. It’s relatively easy for a textile mill owner to add one more mechanical loom: The cost is manageable, and you immediately get more output. On the other hand, if you’ve got a railroad running from New York to Pittsburgh, it’s no good building new track that runs halfway to the next major city.

At this point, if you are a libertarian, you are getting impatient. “There is a solution for this,” you want to tell me, and that solution is, of course, “insurance.” Of course total and unlimited liability would be problematic, which is why most of us would buy car insurance even if the government didn’t make us. But this is a problem that can be solved by recourse to your friendly neighborhood insurance company.

To which I answer: What insurance company?

Insurers are also corporations, and their owners get the same valuable shield from liability that everyone else gets from the corporate form. They may have shareholders, or they may be mutually held by their policy holders, but either way, someone is getting protection from lawsuit by the same laws that protect General Motors Co. This sort of liability shield is vital for any large aggregation of capital requiring lots of contributors -- which is basically the definition of an insurance company.

“But what about Lloyd's of London??!!” you might then ask. Lloyd's of London Ltd. legendarily writes insurance on the basis of unlimited liability. “Names” put up their personal guarantee for a syndicate’s losses, down to the kitchen stove and the commemorative Diamond Jubilee andirons from the sitting room fireplace, and in return, they collect a share of any profits.

But in the 1990s, Lloyd's suffered a crisis as a result of our old friend asbestos litigation. When all the primary targets of asbestos lawsuits started going bankrupt, insurers quite sensibly started refusing to sell them liability insurance. Courts were faced with thousands of plaintiffs, many of them very sick, who had no way to recover. So they ruled that anyone who had ever sold the firm a liability policy could be forced to pay out. This was a problem for a lot of insurers, but it was disastrous for Lloyds, because the way they handled reinsurance meant that the risk ended up concentrated in some of the syndicates, whose Names were wiped out. As a result of the crisis, Lloyds now operates limited liability syndicates that look a lot more like a modern insurance company than its famous unlimited liability model.

The issue is not -- or not precisely -- that unlimited liability firms can’t work under any circumstances. Rather, it’s that they don’t work under modern tort law. True, owners used to have a lot more responsibility for a firm’s actions. But corporate liability has also expanded. In 1930, you could sue a manufacturer -- and win -- because it had sold you a box that was supposed to contain baking soda but actually contained rat poison. But you could not, for instance, sue because you thought that the automobile you had purchased could have been better designed. Or, rather, you could not have won that lawsuit under the legal doctrines of the day. Much less could you sue a tobacco company or a fast-food restaurant on the grounds that they shouldn't have abetted you in your vices.

Tort law and corporate form have evolved together. You can argue, in fact, that judges allowed liability to expand so far in part because corporations were increasingly perceived as faceless bureaucracies, rather than extensions of a single owner who could be destroyed by an excessive judgment. Whatever the case, you cannot simply return to the old rules about firm formation while leaving the modern rules about liability in place. The result would be economic catastrophe as everyone tried to get their personal fortunes out of the business world, where they might be exposed to ruin -- unpredictable, essentially unknowable ruin, because even if a lawyer can assure you that everything you’re doing is legal today, they can’t make any guarantees about tomorrow. It was black-letter law that you couldn’t sue a tobacco company for giving you cancer … until, suddenly, it wasn’t.

Does this mean that owners won’t watch their companies closely enough? Sure, though I’d point out that even people with every incentive in the world to know what’s going on in a large organization often don’t, because information travels through a bureaucracy the way movie heroes travel through quicksand.

The correct question isn’t whether there are costs to limited liability; the correct question is “compared to what?” And if the alternative is undoing the Industrial Revolution, I don’t think that’s a fair trade.

To contact the writer of this article:Megan McArdle at mmcardle3@bloomberg.net.

To contact the editor responsible for this article:James Gibney at +1-202-624-1863 or jgibney5@bloomberg.net.

Megan McArdle is a Bloomberg View columnist who writes on economics, business and public policy. She is the author of "The Up Side of Down."
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